The Two Biggest Risks Facing the Market Today–and What to Do

The best way to win is by not losing, says Bhansali, who oversees $6 billion as the chief investment officer of international and global equity strategies at value shop Ariel Investments. Bhansali, 50, has spent the majority of her career in foreign stocks, including researching emerging markets at long-short firm Soros Fund Management when it was a hedge fund. After five years as an analyst and fund manager at Oppenheimer Capital, she led MacKay Shields’ international equities strategy for a decade, prior to joining Ariel in 2011.

Bhansali focuses as much on what can go wrong as what can go right. She connects industry trends with economic and political developments to spot faulty assumptions in some of the world’s most-loved stocks—and find the unappreciated attributes in issues that investors have dumped. The approach led Bhansali to hedge Thai baht exposure in the 1990s, saving clients’ money during the Asian financial crisis; avoid popular Spanish stocks in the early 2000s after noticing the government’s overdependence on property taxes and land sales; and dump U.S. bank shares in 2006.

Risk aversion didn’t pay off during the bull market, but has helped this year, as some emerging markets have entered bear market territory. Though the Ariel International (AINTX) and Ariel Global (AGLOX) funds she manages beat their benchmarks over the past five years, they rank toward the bottom of their categories during that stretch. Yet both shone when the markets took hits in 2014 and 2015, and have fared much better than peers this year, with the global fund up 3.7% and the international fund down 2.4%, less than half as much as the benchmark.

Barron’s sat down with the contrarian investor in her New York office to talk about the risks investors are ignoring, why she thinks
Apple
(AAPL) faces trouble, and the crisis she believes China faces.

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Barron’s:What’s the biggest risk facing the market today?

Rupal Bhansali: The biggest risk is political. It is manifesting itself in economic policies that affect stocks. A wave of populism is sweeping the world. Mexico just elected a populist president. Populism is on the rise in America, whether we call it that or not. In the United Kingdom, Labour Party leader Jeremy Corbyn’s pro-Brexit populism is gaining traction. This sort of political regime change has given rise to currency wars, and now tariff and trade wars. Countries think that by putting up tariff barriers, they will protect certain sectors of the domestic economy. But tariffs alter prices only temporarily. The real issue is the need to improve productivity.

Rising interest rates are another risk. The equity markets will have to take their cue from the fixed-income markets. Equity investors failed to do that in 2007, to their detriment. The economic news was generally bullish at that time. Commodities were doing well, and other indicators of economic activity were flashing green lights. The bond market, however, was flashing red, in particular the high-yield bond market. This is something to watch.

What is the bond market signaling now?

U.S. interest rates have gone up rapidly at the short end of the [yield] curve. Not so long ago, we were worried about the risk of deflation and rates falling to zero. Now the six-month Treasury bill yields more than 2%. The Federal Reserve is on course to keep hiking interest rates. No jawboning by President Donald Trump is going to prevent the inevitable. Spreads will widen if rising rates cause more nonperforming loans and defaults. We haven’t reached this tipping point yet, but when we do, junk bonds will fall first, and equities will follow.

China has a trade feud with the U.S., enormous debt, and an authoritarian government. Is this cause for concern?

I have always had a negative view on China. Emerging markets generally don’t have an institutional framework to deal with problems, so when they arise, chaos often ensues. The Chinese legislature recently abolished presidential term limits. That’s as authoritarian as it gets.

China had an investment boom, and now has a debt overhang and excess capacity. It’s where Japan was after 20 years of postwar reconstruction, which also involved humongous infrastructure investment. The unwinding of all those years of investment is going to be painful for economic growth. That’s why China keeps announcing fiscal stimulus. It can buy time because of the nature of its government and the size of its foreign-currency reserves, but unwinding its credit binge won’t be orderly.

Yet China is one of your largest country positions.

My job is to mitigate the risks as best as I can. I try to do that by buying companies with cash on their balance sheets.

Such as?

China Mobile
[CHL] is one of my top ideas. The company has about $60 billion in net cash and bank deposits, and the stock, at 7.5 times cash-adjusted earnings, is dirt cheap. That’s where
Microsoft
[MSFT] was trading in 2012. The issue is that the government keeps asking it to lower prices. The market is mistakenly reading this as an indication that the company won’t be allowed to make much money. But China Mobile has 800 million subscribers, four times the number of U.S. mobile-phone subs. It has a 60% market share, and when it lowers prices, the competition has to lower prices, too. So the very intervention that people think is bad news, we think is good news. The competition can never catch up. The government is actually helping China Mobile cement its monopoly.

Microsoft is one of your biggest positions, but it no longer is a contrarian play. Why do you still own it?

Every contrarian pick has to become a consensus one, otherwise, we would never make money. But there is still a lot of growth in Microsoft that the market hasn’t priced in. Azure, its web-services platform, has good growth prospects, as does Office 365, and even Xbox. The same goes for LinkedIn, which Microsoft acquired a few years ago and intends to integrate into its customer relationship-management software. There are multiple vectors of growth. The key to investment success isn’t what to own, but what not to own.

What should investors not own?

Apple. People think of Apple as the poor man’s technology stock. At 16 times forward earnings, it is cheap, compared with
Facebook
[FB] and
Netflix
[NFLX]. But Apple isn’t a technology company. It’s a consumer-electronics company, and consumer-electronics companies have lots of hits and misses. Second, you want to be wary of a company that is losing its competitive advantage. The definition of a franchise isn’t just having a competitive advantage, but building on it and sustaining it. Apple is the opposite of that. When the iPhone came out in 2009, it was revolutionary. It offered tremendous differentiation. Fast-forward nearly a decade, and the iPhone X was a commercial flop. Consumers didn’t see value in an incremental upgrade. Apple is losing its competitive edge. Other companies were first to market with beveled-edge screens and other innovations. When you offer a high-end phone, you need high-end differentiation. Apple doesn’t have it anymore.

So far, Rupal, the market disagrees with you.

The bulls will also argue that the U.S. is a mature market for Apple and that emerging markets offer a great growth opportunity. In emerging markets, this phone is so overpriced. The per capita income isn’t there to support this phone. And other players are coming up with neat phones at a very competitive price. Even though Apple had a bad quarter in terms of revenue, they announceda bazooka of a share buyback—$100 billion—which is why earnings per share came up. That’s what
IBM
[IBM] did not that long ago;
General Electric
[GE] did the same thing. That is financial engineering. You can only kick the can down the road for so long.

So would you recommend shorting Apple?

There are better shorts out there. Apple is still a net cash company. When you short, you don’t have to just know if it will go down, but when it will go down. Another company to avoid: Netflix. Their content costs are going up the wazoo. Their debt has gone up—and they have taken it out to spend on content, which is a very risky move.

Debt has been a big issue for the emerging markets recently. What is your view of the financial crisis in Turkey?

Turkish corporates are likely to default on their foreign currency bonds unless they restructure them. With oil prices rising and a strong U.S. dollar, Turkey will soon need to finance $100 billion a year, without any help from the private capital markets, which have shut the door in the wake of poor economic policies adopted by President Recep Tayyip Erdogan and his son-in-law economic czar. An International Monetary Fund bailout would have been the natural solution, but Erdogan is adamant that he does not want any help from “economic hit men.” Turkey has no choice but to implement a tough austerity program and reduce its fiscal and trade deficits and debts in foreign currencies—an anathema to Erdogan, who wants to pursue a growth agenda.

What does that mean for emerging markets?

We are nowhere near a bottom. Emerging markets should trade at far lower multiples due to their higher risk profile, but investors are enamored with their higher growth profile and pay up for it. When growth disappoints and risk resurfaces, they rush for the exits—as they are in Turkey. We sold our Turkish stocks as early as first-quarter 2016; risks were rising and we were not being paid to assume them. I would wait for a larger correction before jumping in.

So what do you want to own?

People are underestimating the growth potential of
Nintendo’s
[7974.Japan] Switch console. The multiplayer and interactive games they have introduced is game-changing, and there is a very big possibility that, instead of having one Switch console in the house, you have two because you can take it with you.

How does the trend toward cloud- and platform-based gaming affect Nintendo?

This is the hidden value. Companies like Nintendo have always worried about piracy. As broadband access increases in emerging market countries, Nintendo can host their software gaming platforms, allowing for downloading of games on a subscription basis. That helps tackle the piracy issue and opens up a whole new market. And unlike
Sony
[6758.Japan] and Microsoft, Nintendo makes the bulk of its titles, so the company doesn’t have to share the economics. One area I’ve been disappointed in is their mobile strategy. But their new chief executive [Shuntaro Furukawa] has a much more progressive attitude toward the mobile strategy. If mobile were to kick in, that’s a huge new vector of growth. It is growing earnings at 20%-plus, and it is still early in its growth. Plus, they are a net cash company.

What’s the case for all the energy stocks you own?

I’m very bullish on oil. Prices could go up a lot—even if it is temporary—because there are bottlenecks emerging in pipeline infrastructure in the shale Permian Basin. That could last 12 to 18 months. We like the shale-fracking companies like
EOG Resources
[EOG] and
Pioneer Natural Resources
[PXD]. We also own
Schlumberger
[SLB], which is losing the battle to win the war. The stock has been a dog and has lagged behind the oil rally; it’s a late-cycle story, and investors want something much more immediate. There are a lot of projects, and once that goes back up, Schlumberger benefits. In the meantime, it pays a 3% dividend yield and has a new management team that is fundamentally overhauling the business, improving productivity. There’s nothing like a bear market to focus your attention on costs and processes.

Drug stocks have also had a rough time in recent years, but you own several. What is the draw?

You can differentiate between companies with organic prospects, versus those that are much more financial-engineering-oriented. Companies like
Sanofi
[SAN.France] and
Pfizer
[PFE] didn’t do research and development; they just did mergers and acquisitions. It’s a telltale. We are biased toward those with their own R&D capabilities, like
Roche Holding
[RHHBY] and
Gilead Sciences
[GILD]. The biggest fear for Roche is that its top three blockbuster drugs are going off-patent, and people fear the erosion [of sales] will be as steep for biosimilar competition as it is from generics. We disagree. And, they are completely ignoring the new drugs already in the market—one for multiple sclerosis and another for hemophilia—which have even bigger blockbuster potential. Also, Roche has terrific capability in immuno-oncology, which is the hottest trend in cancer therapies. But they are a very conservative company. They tend to not to talk about their breakthroughs and data as much as some of their American counterparts, so people think there is nothing there.

What will it take for Wall Street to recognize this?

What it always takes—a big market correction and people figuring out “I’ve overstayed my welcome” in all the wrong stuff.

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